Remember Grexit? It feels like 2012 again as 'Quitaly' roils markets

Nearly six years ago, when Europe was facing the prospect of a Greek exit from the eurozone, all it took was European Central Bank President Mario Draghi assuring the bank would do "whatever it takes"’ to calm markets.

This time, if the prospect of a "Quitaly" - an Italian withdrawal from the eurozone - were to firm, that might not be enough.

"Whatever it takes" may not be enough this time for ECB President Mario Draghi.Credit:Bloomberg

The ECB response to the Grexit threat was to embark on a massive program, purchasing the bonds of weaker countries of the eurozone and granting a series of bailouts for Greece in return for promises of financial discipline.

Yet where Greece was a minor economy whose exit from the eurozone wouldn’t necessarily have threatened its break-up, Italy -- the zone’s third-largest economy -- poses a challenge of a different magnitude.

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With Brexit already underway, Quitaly represents an existential threat to the eurozone and the 61-year-old European project.

Markets shudder

The seriousness of that threat is underscored by the turmoil in markets overnight and the extent of how the spectre of what could evolve into a referendum on Italy’s membership of the eurozone infected markets beyond Europe.

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In Italy itself, the confrontation between President Sergio Mattarella and the odd coalition between the eurosceptic, anti-establishment Five Star Movement and the right-wing Lega Nord saw the yield on two-year government bonds -- still negative last month -- soar to 2.8 per cent; 10-year yields blew out 48 basis points to 3.164 per cent, their highest level in five years.

When bond prices fall, yields increase, offering investors a higher reward for the risk they take on. Italy's soaring yields are an indicator that investors now see higher risks associated with buying the country's debt.

Flight to safety

On the other side of the Atlantic in the US, yields on 10-year Treasuries posted their biggest single-day fall since the Brexit vote in 2016. Having yielded more than 3 per cent earlier this month, they fell 15 basis points to 2.78 per cent overnight. The yield on two-year Treasuries was down 17 basis points to 2.32 per cent.

The US yield curve, with the difference between two-year and ten-year treasury bonds now only 42 basis points, is as flat as it has been since the global financial crisis, which points to expectations of a weaker outlook for US economic growth.

European and US stocks also fell sharply, with banks hit hard, and the euro wasn't spared either. Meanwhile, the US dollar – and the Japanese yen and Swiss franc -- all strengthened overnight in what was an obvious flight to safe havens. The markets were in "risk-off"’ mode.

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Stand-off in Italy

The crisis in Italy came after the alliance that formed government after the March elections nominated Giuseppe Conte, a law professor with no political experience, as prime minister. Economist Paolo Savona, an extreme eurosceptic, was proposed as economic minister.

President Mattarella rejected the nominations. Provocatively, he appointed a former IMF official, Carlo Cottarelli, as interim prime minister with responsibility for forming a "technocratic" government.

Southern Europeans resent the IMF for -- along with the ECB and European Commission -- imposing harsh "austerity" measures and tough debt and deficit rules on distressed economies post-crisis.

Given the likely lack of support from the alliance, it appears almost inevitable that Italy will have a fresh election in September, with the very real prospect it will effectively end up as a referendum on Italy’s continued membership of the eurozone.

Bitter aftertaste

Despite a general recovery in EU economies – they grew at 2.5 per cent last year, their strongest growth for a decade – the economic underpinnings of the eurozone, particularly in southern Europe, remain weak and vulnerable.

Compared to the economies in the North, southern European economies have lagged in the sluggish post-crisis recovery and their debt-to-GDP levels are higher than they were in 2008. Italy’s is above 130 per cent.

Fed up: Southern Europeans resent the IMF and the bigger European economies for their harsh "austerity" measures and tough debt and deficit rules.Credit:Bloomberg

Where Mario Draghi was able to calm markets in 2012 with words, and then a big dose of central bank liquidity, the issues that have made Italy a threat to the EU and euro aren’t so much financial, as they were then, as political.

But a Quitaly would still create financial chaos, with other weaker EU members almost certainly following Italy out of the eurozone.

Common markets and rules and regulations would be torn up, new currencies and their value would have to be established, financial markets would implode, the European banking system destabilised to the point of collapse, sovereign debt investors would be exposed to huge losses as the denomination of their investments was switched from the German and French-anchored euro to lira, pesos and drachmas.

There would be tidal waves of capital – and waves of losses -- fleeing Europe as investors and financial institutions scrambled to the exits.

Another GFC?

There would be another global financial crisis, with less capacity for central banks and governments to respond to it than there was in 2008.

Yet it is in fact the very prospect of something worse than the last global financial crisis that may prevent all of this from occurring.

The moderates in Italy, and the institutions and key political figures within the EU, will try to counter the eurosceptics by arguing that life outside the eurozone would be even worse than life within it.

Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.